US monetary tightening will expose European vulnerability

Emerging market economies change their tuneSurprising that investors are surprised

by David Marsh

Mon 24 Jun 2013

The basic problem besetting Europe is lack of growth. Signs of buoyancy from across the Atlantic should be welcome in the Old Continent. Unfortunately, the beneficial aspects are likely to fade into the background. American interest rate tightening will expose the true state of European vulnerability that had previously been covered up by a wave of central banking liquidity.

The gradual unwinding of the Federal Reserve’s extraordinary asset purchases as the US economy slowly recovers has been one of the best-trailed interest rate events in monetary history. For many months, US monetary officials, speaking in private, have been expressing concern about possible collateral damage that could be wrought by future quantitative easing (QE) dismantling, including the effect on the value of banks’ holdings of bonds. It's surprising how some investors appear to have been caught out.

The main victims up to now of real and prospective US monetary tightening have been emerging market economies, with countries as varied as Brazil, Turkey and Indonesia in the firing line – developments which have not been helped by social unrest in the first two countries. But wider repercussions are likely across the euro area, in a volatile state on account of highly disparate economic developments in the 17-nation bloc and the prospect of rising financial market nervousness ahead of the German elections on 22 September.

On numerous occasions in the past 30 or 40 years, American monetary tightening has had a negative impact on various European exchange rate regimes. The same is true of German elections, which in the past were often the trigger for European exchange rate realignments; under monetary union, such adjustments cannot take place. But a combination of both sets of circumstances could bring a bumpy ride, contrasting with Chancellor Angela Merkel’s wish for summertime euro calm to help secure her hold on power.

World economic management is getting ever more complex in view of great heterogeneity in different groups of countries’ economic performance. Europe remains mired in diversity with euro bloc states collectively bumping along the bottom and no sign of sustainable growth in recession-hit debtor nations.

Normalisation of US interest rates – although generally a welcome sign of the robustness in the world’s largest economy – accompanies disturbing signs of slower growth in China and other now-less-dynamic developing countries. Developing nation economic leaders such as Guido Mantega, Brazil’s outspoken finance minister – who two years ago accused the US of launching 'currency wars' through QE and a lower dollar, allegedly to steal a growth advantage – have been forced to change their tune.

The bull run in peripheral European bonds promoted by the European Central Bank’s unused OMT bond-buying programme has juddered to a halt. I still think the OMT will go down in history as a splendid psychological coup that was never implemented.

Apart from signs of wrangling over topping up official credit programmes for Greece and Cyprus, there have been other signs of strain in the last few days. EU finance ministers failed to clinch an accord on new rules for bailing out European banks after a marathon session that ended early Saturday morning, although no doubt some sort of compromise will be hammered out next week. And the European Investment Bank rejected the notion that it could put together large-scale securitisation packages for loans to medium-sized enterprises, scotching a suggestion by Mario Draghi, the ECB president, that the EIB could somehow ride to the rescue. The barometer reading for monetary union is moving towards 'stormy'.